Embedded finance and banking as a service (BaaS) are arguably some of the most underrated and promising growth points in the mainstream payments industry. This article will talk about embedded finance, how it works, and the future of embedded finances.

In This Article:

  1. What is embedded finance?
  2. Embedded finance — how it works?
  3. Examples of Embedded Finance
  4. Benefits of Embedded Finance
  5. Use Cases Of Embedded Finance
  6. How is it revolutionizing financial services?
  7. Trends in the Embedded Finance
  8. Instead of conclusion

What is embedded finance?

Let's start with the embedded finance definition. Embedded finance is a new trend in modern financial technologies that integrates loans, insurance, debit cards, and investment instruments with almost any non-financial product. It is essential for e-commerce, where the profit and loyalty of the consumer depend on the transaction speed. Why force a client to go to the bank for a loan — fill out a questionnaire, undergo an assessment, and wait for approval — when you can add the option "on credit" or "in installments" to the store's website and help him complete a purchase in 2 clicks?

Today, the financial sector is rapidly evolving under the influence of several factors, including competition from new players, commodity payments, government regulation, and new customer expectations. Recent technological and business reality is constantly emerging, to which it is necessary to be able to quickly adapt — not only for banks but also for FinTech companies. Gone are when FinTech had a monopoly to disrupt the payments industry. Today, there is confusion: banks are buying up startups and actively developing their digital services, while FinTech seeks to obtain a banking services license and, with its help, independence in decisions, as well as commission income.

At the same time, both banks and FinTech companies face the problem of expanding in a market overflowing with quality offers — a call with decreasing commission income, including due to the actions of regulators. Fintech meets the pain of growing a client base for a new brand — the cost of attracting a client is very high due to competition with banks that already provide them with their service. Almost the only opportunity is to quickly enter narrow niches with a built product for them with minimal investment. On the other hand, the explosive growth of FinTech demonstrates the inability of banks to quickly respond to market changes and enter such niches on their own.

In addition to banks, there are many brands on the market with a strong reputation that could provide financial services at a significantly lower cost of attracting new customers. At the same time, they lack the infrastructure and expertise in payments. Moreover, not all companies are determined to develop such services internally, receiving them by subscription via the API. By leveraging embedded finance and BaaS, brands can focus on product development while banks and FinTech gain a new untapped market. Moving to a product and service model and working effectively through partners seems the new normal.

Understanding embedded finance as a change in providing financial services is more correct, not the emergence of another type. Such processes are typical for the payment industry. For example, in the card industry, contactless EMV payments have steadily replaced contact bank cards and soon will, in turn, be replaced by a tokenized form in a mobile phone. It is essential to understand the underlying driving forces that will lead to the new phase shift.

Embedded finance — how it works?

Simply put, embedded finance services allow any business to manage and market innovative financial services. Every company can now seamlessly integrate creative forms of banking products as payment, debit, credit, insurance, or even investment into end-user experiences. A straightforward example is paying for a ride with Uber. You will not receive your credit card at the end of the journey. Uber's product designers have made payments built into your app, while the driver gets the right amount at the end of the ride.

Payment facilitation companies such as Stripe and Square have increased over the past decade, bringing these opportunities to digital businesses. They are now worth $36 billion and $57 billion, respectively, expanding their capabilities in other areas.

The complexity increases as you move from payments to debit, credit, insurance, and investment. But if you are a marketer or brand in any sector, you want your offerings to customers to be as attractive as possible. Today, customers have to interact with their banks to get debit and credit cards, sofa, car, or home loans, and there are many disputes between the customer, the bank, and the seller. Below we will look at several options tailored to the needs of individual clients. Klarna has grown into a $5.5 billion company, enabling brands to offer innovative lending customized financial solutions at the time of purchase, such as through installment payments.

Lambda School offers online training for potential programmers. It provides various payment options, including an income-sharing agreement that charges students a portion of their future income rather than an upfront tuition fee. The student contacts the school directly about this and other proposed payment options rather than seeking a bank loan. It can be attractive to everyone.

The integration of the financial services industry is also overgrowing. For example, you can provide your car-sharing service with automatic mobility insurance or give your new camera protection against theft and damage right out of the box for the total cost. Some of this is happening today. British Airways offers travel insurance on its website when you purchase your flight. But so far, integrating these offerings for brands and sellers has not been quick or cost-effective. They are generally generic and managed by the insurer rather than customized by the brand in real-time.

Ultimately, financial services will fade into the background of the solution offered to the client. British Gas has already stopped selling "boiler insurance." It now provides "remote boiler maintenance" (thanks to IoT-optimized underwriting), a much more attractive proposition.

Embedded finance — as opposed to resale financial services — is attractive to digital brands and merchants because it creates new revenue opportunities at meager marginal costs (the brand already has a customer base). It provides new customer experiences that drive loyalty and repeat online purchases and allows sellers to understand relationships' economics better.

It could potentially allow them to double their revenue per customer by two to five times for software companies. For example, Shopify, a B2B e-commerce platform, currently makes over $500 million a year from financial services for its sellers (growing at around 50% per year). The underwriting cost is much lower as Shopify already has vast data about its users. For many software and platform companies, financial services will become an increasingly profitable addition to their core business.

Examples of Embedded Finance

Installment payment services (BNPL) are seamless lending that integrates especially well with large online stores and marketplaces — OZON, Shopify, Amazon, Walmart. Clear business history and the ability to work in isolation make these services attractive to embed in a service model. Again, according to a Solarisbank report, 42% of people surveyed in Germany have used Klarna, one of the largest BNPL services, at least once in the past 12 months. There is a difference from 95% for PayPal, but the penetration rate is very high even in conservative European markets.

The offer of KYC services in the form of an embedded service, although not directly a financial service, is, however, a part of the necessary infrastructure, without which it will be impossible for non-banks to provide financial solutions. By the way, there are quite a lot of companies on the embedded finance market that provide this type of service, which can be partly explained by the rapid development of alternative finance in blockchain ecosystems, which are forced to use KYC under pressure from regulators.

The video game economy is another large segment in which financial products can be applied. For quite a long time, almost the only option for economic interaction was selling a game account on unofficial sites. However, the leverage of embedded finance as blockchain technologies and smart contracts led to the emergence of the GameFi direction. The in-game currency is traded on crypto exchanges, as are in-game items in NFT form. The potential of this area is enormous. For example, the token capitalization of one of the first Axie Infinity games is currently more than $8 billion.

In addition to the full set of DeFi tools, it remains possible to work with traditional financial instruments, allowing you to make online purchases on an installment plan or on credit.

BaaS platforms are in great demand among neo-banks, for which it is extremely important to be able to focus on the product without being distracted by building the payment infrastructure, which they can get through the API. A prime example is the ClearBank-OakNorth alliance or the Solarisbank-Tomorrow collaboration. Large banks can launch niche neobanks based on BaaS solutions, accelerating time to market, reducing transaction costs, risks, and embedded investments in infrastructure. For example, Crédit Agricole did this with a digital bank for freelancers Blank and BN Amro with the Moneyou neobank.

Benefits of Embedded Finance

Of course, embedded finance has a number of benefits for both users and businesses. But today, we will dwell on the benefits for business in more detail.

Embedded Finance

Use Cases Of Embedded Finance

A classic business case is integrating conventional payment services into non-banking companies, for example, the alliance of the Mexican BBVA and Uber. Due to the extended functionality of the merchant application, drivers can receive payments within a few minutes, as well as get direct access to loans, discounts, and cashback at a gas station.

Moreover, such services can be not only from the acquiring side but also from the emission side. For example, watchmaker Swatch provides the ability to issue tokenized payment cards on a number of its watches through SwatchPay. Amazon and Apple offer their own credit cards.

How is it revolutionizing financial services?

When planning the implementation of promising innovations for financial institutions, it is essential to understand whether this solution is a bold experiment or a necessary part of the service that competitors will offer in two or three years. In both cases, an error can lead to losses, and it is not yet known in which version they will be greater.

Embedded finance refers to non-financial companies that have value propositions that expand significantly or even transform with embedded related financial products and services.

The experience of global companies in various verticals, from search engines (Google with Google Bank) to on-call services (Grab with GrabPay) to marketplaces (Amazon Pay), shows that embedded finance companies have an advantage in offering financial services through distribution, data, and resources.

At a high level, we see a three-step evolution in financial services.

  1. First, financial services came from banks and other financial institutions, universal financial institutions. For example, bank transfers as a means of transferring money from one organization to another.
  2. Second, the Great Bank Separation led to the emergence of many first-wave FinTech companies that focused on using technology to provide financial services outside/on top of the traditional banking process. For example, Paypal for online payment.
  3. Third, the great democratization of financial services has led to certain financial transactions (potentially segmented by customer or industry type) that are better served or distributed by specific petro-technical platforms. For example, WeChat Pay for p2p payment transfers.

Revolutionizing Financial Services

It is important to note that by conducting a global scan of embedded finance companies, we see that startups are taking advantage of even greater separation of the various stages of the financial value chain. Overall, we see three main ecosystem stages that correlate with the complexity of the embedded finance ecosystem.

The first phase focuses on distributing financial services through the existing platform. We see that this is more common in Asia, where distribution and education remain the central issue. These companies are looking to focus on building an ecosystem of services that seek to integrate deeply into the value chain within their specific vertical. The Shopify mentioned above, Udaan, Grab, and others in this space.

The second phase aims to provide communication between FinTech and non-FinTech companies. It is an acknowledgment that financial services are complicated to manage correctly (especially for companies without institutional knowledge and capital investment). The catalysts for this are twofold: regulators insist that products and services remain in the hands of banks, and banks want to engage in advanced financial technology. By focusing on connectivity, these companies optimize the distribution of financial services. Companies in this area include Flexmoney, Plaid, Instacred, etc.

The third stage aims to integrate financial processes through the existing platform. As platform ecosystems grow more significant with more payment/transaction flows on the forum, reliance on external financial processes (payment processing, facilitation, etc.) becomes more prominent. While it may not make economic sense to build and maintain such platforms in-house, startups provide an opportunity for B2B companies to embed white-label finance from the outset into their digital ecosystems. Companies in this space include Finix, Matchmove, DriveWealth, which are focused on allowing existing ecosystem players (like Shopify) to offer their white-label financial stack. For example, Finix will enable platforms to have their network to facilitate payments. It will allow such e-commerce tools (like Udaan) to have their internal payment stack. They can then start charging a variable rate, negotiating with appropriate partners, etc., emphasizing infrastructure as a service. They are building more robust proprietary financial ecosystems.

The Hierarchy Of Embedded Finance

Below you can see a high-level map of what the potential opportunities in various industry verticals might look like.

The Potential Opportunities

The opportunities for embedded finance are exciting as fundamental levels of digitalization occur in traditional industries. It allows companies traditionally unrelated to financial technology to build financial services. As Embedded Finance companies continue to separate financial processes, the hierarchy of separation that we see will be repeated in ecosystems worldwide.

By learning from what is happening around the world in the US, India, China, and other ecosystems, we see the future of embedded finance platforms.

At the moment, there are several significant trends for BaaS and embedded banking that are critically important for banks to track to keep up.

All in one

Human attention is the critical currency of the 21st century. Much of this attention is channeled through a smartphone that has hundreds of mobile apps installed, including social media. Because it is tough to keep in mind the laws and structure of each service, people naturally gravitate towards ecosystems of different, equally organized products that third-party partner companies can provide.

Natural demand

FinTech organizations have created a robust global demand for payment services that consumers expect from extensive technology and other non-banking companies. According to a study by Solarisbank, 61% of respondents are willing to use financial services provided by brands they trust. Moreover, such companies cannot cope with this request on their own due to complex regulatory restrictions and the lack of the necessary expertise. BaaS presented as a boxed solution ideally addresses this market demand.

Open API

Currently, the Open API reflects two trends. First, this is the transition to the Web 3.0 paradigm, within which each person owns all their data and can quickly revoke access to them from third parties. Secondly, central banks have a regulation that introduces directives like PSD2 to stimulate the development of quality services and competition.

At the same time, PSD2 quite clearly divides market participants into account operators and financial service providers. Having lost the exclusive right to be the sole service provider for its client base, the bank can sell payment expertise and infrastructure to those who will try to take advantage of technological and market changes.

Technological changes

The move from mono-core architecture to microservices and containers made it technically easier to create dedicated services. By gradually bringing all their IT systems to a set of dedicated services and APIs, the same banks will find it easier to perceive the idea of providing their services in the form of White Label products to other companies.

Accordingly, companies looking for an opportunity to integrate financial services into their ecosystem are now beginning to perceive payment services as a set of modules assembled by other companies as well. In turn, the issuance of loans, embedded payments, and deposits are, for them, nothing more than an extension of the existing product line, an extension of the user experience. It becomes easier for banks to make decisions about launching technically accessible and ideologically understandable projects.

Thus, technological, regulatory, and economic changes converge at one point, unexpectedly tightly correlated with the demand from end-users. They, in turn, expect a simplification of the user experience when interacting with financial products and are also less and less of the opinion that financial services should be provided exclusively by banks.

Instead of conclusion

Embedded finance tools allow you to integrate payments, debit cards, loans, insurance, and even investment instruments into almost any non-financial product. For example, you can get embedded lending directly on the digital platforms of an online store or a supplier company without filling out questionnaires. And users can transfer money through applications that, it would seem, have nothing to do with finance. This approach will increase the profits of banks and FinTech, as it will allow them to compete with players who are trying to drive customers into their banking applications.